An Introduction To Technical Analysis: Charts & Indicators

In Summary: 

  • Technical analysis relies on historical price action to make educated predictions on future movements
  • It involves reading chart patterns and the application of technical indicators to measure aspects of price action



Smart trading, unlike betting, is founded on research and reasoning. Before opening any live positions, traders can draw on diverse data sources to monitor market trends, gauge sentiment, and even anticipate where prices are headed next. The most common strands of analysis used by traders are technical, fundamental, and sentiment.  

What Is Technical Analysis? 

Technical analysis is the method employed by traders who scrutinize past price movements in order to make future predictions. Unlike fundamental and sentiment analysis, technical analysis focuses exclusively on price data; it does not encompass broader economic indicators or geopolitical factors, such as inflation, interest rates, or economic depression.  

Instead of measuring the intrinsic value of an asset, technical analysis is used to find patterns in market movements and identify logical trade entries. The simplest form of technical analysis is the study of chart patterns. Traders learn to identify particular price movements, such as head and shoulder formations, pennants, flags, or wedges and place their trades accordingly. Alternatively, traders can apply technical formulae (indicators) to measure factors such as momentum, volume, and average movement. Unsurprisingly, technical traders are commonly nicknamed “Chartists”. 

Technical analysis has a reputation for being mathematical and complex, but the good news is that it doesn’t have to be! In actual fact, technical analysis encompasses a vast range of methodologies and indicators which can be tailored according to the individual trader’s needs and abilities. Indeed, you don’t have to memorize every pattern or use every indicator in order to benefit from technical analysis. Further, thanks to technology, many indicators that would once have required manual calculation now appear with the touch of a button. 

What Does Technical Analysis Involve? 

Technical analysis is based upon three core principles: 

  1. The history of a price reflects all important information affecting the market. Technical analysts believe all key fundamentals or geopolitical influences will have been factored into price if relevant. 
  2. Prices move in trends, and not by random impulse. Technical analysis is the search for patterns in the chaos of the market. 
  3. History often repeats itself. Traders across the globe analyze the same price data, so it is natural that they will frequently draw common conclusions. This means that technical analysis can become self-fulfilling if enough traders trade on the same predictions, and markets are liable to react similarly to recurring events. 

The simplest form of technical analysis is the study of chart patterns. Traders learn to identify particular price movements, such as head and shoulder formations, pennants, flags, or wedges and place their trades accordingly. This visual interpretation demonstrates the close alignment between technical analysis and trading psychology; the more traders spot a pattern, the more trades will be placed, and the ‘analysis’ becomes self-fulfilling. 

Limitations Of Technical Analysis 

  • Obviously, technical analysis cannot anticipate freak fundamentals. Natural disasters, political upheavals, wars, or economic indicators that miss predicted figures are examples of instances where sudden market reactions can catch technical traders out. If you only consider historic price data, you will have no insight into upcoming or current events that can influence the markets. This is why even the strongest technical trader should keep an eye on fundamentals (i.e. watch the news) to ensure their technical conclusions remain relevant. 
  • There is no objective truth in technical analysis. Traders use it to advise the placement of their trades, and in plenty of circumstances, as mentioned above, patterns are self-fulfilling because traders overwhelmingly respond to the same technical signals. But on the other hand, different traders can draw very different conclusions from the same price data. Sometimes, you will only be able to spot patterns with the benefit of hindsight, which can be frustrating and make you question your progress. 

Types Of Technical Indicators 

Thanks to computer trading platforms, traders have access to hundreds of technical indicator iterations. With systems such as MetaTrader 4 or 5, traders can apply a range of pre-programmed indicators with a simple click; moreover, MT5 actually allows advanced traders to program their own custom indicators and share their setups with other users. But most importantly for us, this technology makes it easy for beginner traders to start experimenting with indicators. 

Technical indicators fall into two major categories: 

  • Lagging Indicators 

As the name suggests, lagging indicators give signals after trends and price movements have already started. They are most useful for confirming the strength of trending markets.  

The Moving Average, which averages price movement over a given period, is one of the most common examples of lagging indicators. 

  • Leading Indicators 

Leading indicators, on the other hand, generally use shorter time frames of data to predict upcoming price action. They tend to be more useful in sideways markets when traders are waiting for breakouts. Examples include: 

  • The MACD (Moving Average Convergence/Divergence), which plots two Moving Averages against each other to measure price momentum. 
  • The RSI (Relative Strength Index), which aggregates price gains and losses to measure momentum and identify over-bought or over-sold areas. 
  • The Stochastic Oscillator, which also measures momentum by comparing price closes of a period with the low-high range.

Categories of Indicators Leading Lagging

You will also see indicators divided according to their placement on a chart:

  • Overlays

These are indicators that appear directly on price chart and cover the same time-frame. Examples include Moving Averages, Bollinger Bands, and Fibonnaci Retracements. 

  • Oscillators 

These do not appear over a price chart but instead appear above or below. Examples include the leading indicators described above.

Overlay and Oscillators

Finally, indicators fall into categories according to what they actually do, as described below.

Trend-Followers

These are indicators that measure the strength, direction, and average movement of price to confirm whether or not a trend is established. Moving Averages, MACD, and the Parabolic SAR are trend-followers. 

Momentum Indicators

These measure the speed of price movement to determine whether a trend is continuing or slowing to a reversal. The RSI, Stochastic Oscillator, and CCI (Commodity Channel Index) are momentum indicators. 

Volume Indicators

These indicators use trade volumes to measure the strength of a trend. The VO (Volume Oscillator) and OBV (On Balance Volume) are volume indicators. 

Volatility Indicators

These measure the rate of price change, regardless of direction. Bollinger Bands and Standard Deviation are volatility indicators. 

How To Make The Most Of Technical Indicators 

Technical signals are only reliable if they stand up to thorough verification, otherwise they may provide false trading signals. Not every indicator will suit every market situation, so traders can benefit from being flexible in their choice of analytical tools. 

In general, you can use implement qualifying thresholds to test the strength of your signals. These could include signals that are: 

  • Present for a minimum period of time, so they are not random anomalies. 
  • Within a specific range, i.e. oscillators falling above or below a certain percentage. 
  • Based on reasonable volume; greater data volume tends to yield stronger signals. 



Combining indicators can also help to verify signals. If one indicator presents a significant signal, it can be compared with another different but complementary indicator to check that signals are not anomalous or false. Comparing too many indicators is futile; too much information will only muddy your perspective! 

Most importantly, there is no specific winning ‘technical strategy’. The number of indicators you choose to employ will depend largely on your trading strategy and the time frames you use on the markets. For instance, scalpers and day traders chase fast, frequent trades, so using more indicators will result in more frequent signals. On the other hand, position or swing traders will require less frequent signals to manage their ongoing positions. In any case, it is not worth forcing indicators to fit where you do not fully understand their purpose. 

Summary 

Technical analysis offers valuable tools for traders of all strategies and ambitions. Effectively placed indicators can help you gauge price trends, time reversals, and therefore position your trade entries and exits with precision. However, used in isolation, it can offer a dangerously introverted perspective on the markets, so traders should consider whether other forms of analysis (such as fundamental analysis) would strengthen their strategic planning. 

If technical analysis is completely new to you, hopefully, you realize that it doesn’t have to be too complicated or mathematically challenging! The best way to build your technical skills is to practice placing and reading indicators in a demo account; this allows you to explore different indicators and hone your strategy without endangering any real capital.  

FAQ

What Is Technical Analysis?
What Are The Three Main Principles Of Technical Analysis?
How Is Technical Analysis Performed?

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